How to Manage Inventory While Keeping Costs Down

Safety Inventories and Product Availability

Inventory in global supply chains serves various purposes. It buffers against uncertainties, bridges the temporal gap between production and consumption, and enables economies of scale in production and transportation. Plus, inventory allows businesses to satisfy customer demand promptly, which is particularly essential in an increasingly demanding and time-sensitive global market.

However, maintaining inventory comes with associated costs—holding and carrying costs. Holding costs (also known as carrying costs) are expenses related to storing unsold goods. These costs include the cost of space for storing the goods (warehouse rent or depreciation), handling costs, insurance, taxes, obsolescence, spoilage, and the opportunity cost of the tied-up capital. Warehouse rent or depreciation could either be the rent paid to a third-party property owner or the depreciation of the warehouse property owned by the company. In both cases, the larger the inventory held, the larger the storage space required, and thus the higher the cost.

Handling costs are the costs associated with moving goods in and out of storage. They include labor costs for warehouse staff, fuel and maintenance for forklifts and other handling equipment, and costs related to inventory management systems. More inventory typically requires more handling, so these costs increase with larger inventory levels. Companies also need to insure their inventory against loss or damage. Additionally, some types of inventory can become obsolete or spoil over time (Cho?odowicz & Or?owski, 2021). If demand predictions are incorrect and goods remain in storage for too long, the company may have to write off these goods, leading to losses. Opportunity cost is also a significant but often overlooked cost. The money invested in inventory could have been used elsewhere in the business to generate returns, such as investing in new product development, marketing, or other income-generating assets. The opportunity cost represents the foregone profit that could have been earned from these other investments. Then there is cost of capital, which is similar to the opportunity cost. The cost of capital represents the return that could have been earned on the invested capital if it had been employed in the best alternative investment opportunity with a similar risk profile. Inventory ties up a company's working capital, which has its own cost, usually measured by the weighted average cost of capital.

Reducing lead time (the time it takes from the start of a process until its conclusion) can significantly influence inventory management in a supply chain. When lead times are long, businesses must maintain larger amounts of safety stock to buffer against uncertainties in both demand and supply. Reducing lead time can lower the need for safety stock without hurting product availability. With shorter lead times, forecasts become more accurate as they are closer to the demand period, reducing the variability that needs to be covered by safety stock.

The process of determining how much inventory to order and when to order is referred to as optimal lot sizing. It balances the trade-off between ordering cost (or setup cost) and holding cost. The Economic Order Quantity (EOQ) model is often used to find this balance and minimize total inventory costs. Quantity discounts can also affect the lot size (Sebatjane & Adetunji, 2019). These are price reductions that suppliers offer to buyers for making large-volume purchases. Quantity discounts can influence the decision on how much inventory to order: the buyer might decide to order in larger lots to take advantage of the discounted price, even if this leads to higher holding costs.